What is the Solvency Ratio?

Business Knowledge

The lenders (who are known for doing lending for the earning purpose) of each company from which the company borrows money as debt or loan to fulfill their competitive activities so that lenders check the ability of the company’s paying level. In simple words, we can say that lenders, Banks, or other financial institutions are the holders of calculating the solvency ratio to examine the ability to pay solvency or creditworthiness.

Who mainly used the Solvency ratio?

Lenders: Lenders can be a bank or financial institution or other people who are known as loan service providers. Their relationship with the solvency ratio is important because they offer money to the companies for a prolonged(at least 1year) interest so that the company will invest it into the business operations to gain more profit and goodwill in the financial market.

Lenders apply the solvency ratio because they want to find out what the actual income of the company is, and whether they can pay the loan interest or not before giving a loan. If we describe their role to calculate this ratio that they survey the financial fitness of the company.

Investors: Investors who invest capital in big firms as a shareholder on equity or regular interest. They also used a solvency ratio because they analyze that the company they are investing in is so financially brandable or has so much enough cash to pay long-term liabilities or debt.

Investors apply the solvency ratio because they want to find out the company’s market financial position and summarize with the previous year’s income and business level that their money will not be drowned in that company.

Both have similar motives, both of them play the role of the analyst in one situation so that they can find the financial status( check the eligibility of final income of an organization). Even they compare the company with the other company in the same industry to take out the results such as net income, paying capability of long-term debts or long-term liabilities, expenses, revenue, and goodwill. 

What is the solvency ratio for?

As we said above, it is for measuring a company’s financial strength that they are proficient to pay long-term debts such as bonds, convertible bonds, notes payable, etc. Solvency ratios are otherwise called “leverage ratios” which are looking for a long-term outlook. 

Many people have confusion between the solvency ratio and liquidity ratio but there are major differences between them, solvency ratio identifies the long-term debts, rather liquidity ratio identifies short-term debts.

The Solvency ratio is used to check the availability of cash flow in the business and inspect the net income and throughout the expenses incurred in the business. 

Types of Solvency Ratio

To compute the solvency ratio, companies apply three methods of this ratio to observe the firm’s paying volume with the available cash. This ratio also improves a company’s earning efficiency and paying capacity because it acts as a financial reminder for them.

Debts to assets ratio

Debts to assets ratio are the calculation of the company’s debt by the company’s all assets. 

In simple words, it computes that the company can pay all their long-term debts with the availability of assets or the company or can pay their all liabilities by selling all the obtainable assets.

Debt-to equity ratio: long-term debts/total assets

It takes out the proficiency of the company and easily states the company’s financial performance in front of investors and lenders.

A Higher ratio indicates (<1) the company can pay all the liabilities with the available assets.

Debts-to equity ratio

The Debt to equity ratio is the calculation of the company’s debts by equity shareholders.

In simple words, it computes that the company can pay all its debts with the help of shareholder’s invested funds. Because shareholders are also responsible to pay long-term debts.

Debts-to equity ratio: Outstanding debts/Equity shareholders

It takes out the efficiency of the shareholders of the return level that they are with their company or not in a liquidity situation. Sometimes, companies are in such a situation when the shareholders always have to be financially alert to tackle that worse situation. That’s why this ratio finds out the shareholder’s financial position. 

The higher the ratio, indicates the positive financial position of the company shows that the company is qualified to meet all their long-term debts.

Interest Coverage ratio

The Interest coverage ratio is calculated to find out the earning capacity of the company in a year to pay interest on debts. If a company’s earning capacity is better, obviously they are always able to pay all interest on all debts timely.

Interest coverage ratio: EBIT/Interest expenses

It takes out the company’s capability to run the turnover of all the debts by paying all interest charges on debts. It evaluates whether the company is paying interest regularly or not.

The Solvency ratio is different from the Liquidity ratio because both purposes are to evaluate the staging of a company with long-term debts and short-term debts because this ratio is also a part of financial ratio analysis.

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